Post-Crisis banking regulation: Evolution of economic thinking as it happened on Vox

Jon Danielsson02 March 2015

This column introduces a new Vox eBook collecting some of the best Vox columns on financial regulations, starting with the fundamentals of financial regulations, moving on to bank capital and the Basel regulations, and finishing with the wider considerations of the regulatory agenda and the political dimension. Collecting columns from over the past six years, this eBook maps the evolution of leading thought on banking regulation.

Everybody seemed to be caught off guard by the Global Financial Crisis that started in 2007, not the least the financial regulators. They missed all the excessive risk-taking, the build-up of financial imbalances and the accumulation of vulnerabilities in the years and decades before the Crisis. What went wrong and how can we fix it?

The common refrain has it that there was excessive deregulation and that simply by ramping up regulatory intensity, all will be fine. Does this view stand up to scrutiny? Superficially, the signs point that way. The US distinction between commercial investment banks and investment banks was no more, and neither was Bretton Woods with its assorted restrictions. However, the rest of the world never had the Glass–Steagall Act, and we just replaced macro-regulations with micro-regulations. Broad-brush activity restrictions were swept away, with regulations controlling the minutiae of banks’ operations put in their place. Indeed, the reality is much more complex than most critics would have it. Is not that we didn't regulate with sufficient intensity, we just didn't regulate correctly.

If we want to fix the problem of financial regulations, we need a more nuanced debate, and the place to see that is on the pages of VoxEU.org. The world's leading analysts have debated financial regulations in its columns, avoiding the shrillness of the mainstream media and focusing on solid arguments and sound facts. While the Vox commentators often reach different conclusions, they are precise in their analysis and therefore directly shape the regulatory reform agenda.

This eBook collects some of the best Vox columns on financial regulations ranging over a wide area, starting with the fundamentals of financial regulations, moving on to bank capital and the Basel regulations, and finishing with the wider considerations of the regulatory agenda and the political dimension.

We start with one of the world's most senior regulators during the period of the Global Financial Crisis, Sheila Bair, then the head of the FDIC, who gives a clear 12-point vision of the desirable financial system of the future. She avoids the extremes on either side of the debate and advocates simplicity, efficiency and common sense. This does not mean she avoids controversy, for example when discussing the too-big-to-fail problems, she says: “We have to solve it. If we can’t, then nationalise these behemoths and pay the people who run them the same wages as everyone else who work for the government.”

Hyun Song Shin, now head of research at BIS, considers the fundamental problem of financial regulations, arguing that they focus too much on ensuring each institution is well behaved. In his view, this is a fallacy of composition and he wants us to look at the system and macro-prudential rules.

His BIS colleague, Claudio Borio, discusses the practicalities of the macro prudential approach and some of the challenges in implementing it. My own piece is on the theme of complexity, arguing that regulations should focus on simplifying the financial system and on variables that are easy to measure and hard to manipulate, avoiding regulation by models.

One of the most important questions is the scope of banking. Should we implement some model of narrow banking, perhaps separating out regular banking activities and proprietary trading, or otherwise limit banks to specific activities? Vox has seen its share of columns debating these questions. For example, Arnoud Boot and Lev Ratnovski dislike proprietary trading and advocate the segregation of banking activities, while Charles Goodhart takes the opposite view, arguing that investment banking is essential to the economy and favouring universal banks.

Perhaps the most fundamental and heated debate on financial regulations is the question of bank capital. What is it, what is it for, how should it be calculated and how much should it be? While most agree we have to change the way we calculate capital and that we should have more of it, the Vox commentators disagree on what this means in practice. Raihan Zamil argues that by focusing too much on capital, we miss the big picture, while Jens Hagendorff and Francesco Vallascas maintain that the problem with capital is the way it is calculated – especially the risk-sensitive type – because the risk forecasts are unreliable. One solution would be to calculate capital differently, perhaps with Hans Gersbach’s proposal to use average industry equity.

The main controversy over bank capital is the overall level. In the 19th century, banks routinely operated with capital ratios of 40% or more. The rates have been steadily decreasing since then. Lev Ratnovski wants capital ratios to be sharply increased – to 18% risk-weighted. Charles Calomiris, while also supporting an increase in capital, worries about the economic impact of increasing capital levels too sharply.

Bank capital falls under the umbrella of the Basel regulations, just like so much of the regulatory agenda. Vox certainly has no shortage of Basel columns. Some see Basel as the salvation – that it is fundamentally important and broadly correct. Others disagree, maintaining that it fails to protect or, even worse, increases financial instability and systemic risk. Avinash Persaud offers a strong defence of Basel III, while Adrian Blundell-Wignall and Paul Atkinson argue that Basel III is out of date.

Stefan Schmitz focuses on one of the main innovations of Basel III – the liquidity ratios. He strongly supports them, dismisses critics who say they will have a negative economic impact, and argues that international harmonisation is essential. Not everybody agrees with harmonisation, and Luc Laeven and Ross Levine observe that the governance structure of banks affects how they react to regulations, suggesting that because governance structures differ across countries, one-size-fits-all regulation might be ineffective. One problem with implementing such a broad regulatory agenda as Basel III is that it may not be compatible with other important regulatory initiatives, as discussed by Takeo Hoshi, who argues that Dodd–Frank and Basel III are partly incompatible, and that Basel III will lead to regulatory arbitrage.

Vox columns have also considered the wider implications of the financial system and financial regulations. Franziska Bremus, Claudia M. Buch, Katheryn Russ and Monika Schnitzer argue that banking systems are highly concentrated, with individual bank credit fluctuations affecting the wider economy. In extreme cases, the financial system may have a sudden cardiac arrest, and Ricardo Caballero shows how government should respond to such an arrest.

Financial regulations focus mostly on banks – or to be precise, financial institutions that are legally defined as banks – but much financial intermediation takes place elsewhere, in the shadow banking sector. Stijn Claessens, Zoltan Pozsar, Lev Ratnovski and Manmohan Singh note that shadow banking is important but has been rather neglected by policymakers. Many proposals advocate bringing several shadow banking or OTC activities directly under the regulatory umbrella, for example by moving OTC trading onto central counterparties (CCPs). This is a concern for Manmohan Singh, who argues that a move to CCPs will just shift risk around and not solve the fundamental problem.

Another area that was neglected by financial regulators was the resolution of failing institutions, especially those that operate internationally. The inherent slowness and the national mandate of the legal system frustrate the efficient resolution of failing banks, as addressed by Martin Čihák and Erlend W Nier, who prefer special resolution regimes.

Financial regulations are inherently political, and often it seems like politics has been the dominating force in both the pre-Crisis regulatory failures and the post-Crisis regulatory reform process. The politicisation of regulation gives much room for lobbying, and Deniz Igan, Prachi Mishra and Thierry Tressel observe that bank lobbying prevented the tightening of regulations before the Crisis.

A commonly proposed solution to the inherent incentive problems in financial regulations is to increase the exposure of individual bank employees to the eventual results of the risk-taking. The authorities, however, have been reluctant to expose individual bank employs too much, the EU bonus cap notwithstanding. One reason may be that the authorities may simply prefer to collect fines from the banks. It might be better to apply fundamental economics to the question of financial regulations, and to follow Enrico Perotti’s proposal of a Pigouvian tax on bank's contributions to systemic risk. Perhaps it is time to start locking bankers up when they misbehave, as argued by Giancarlo Spagnolo.

The columns chosen for this eBook represent the broadness and sophistication of the regulatory debate as it played out on the pages of Vox. What emerges from these pieces is the difficulty in regulating a financial system that simultaneously needs to be safe and also contribute to economic growth. What I take from the debate highlighted in this eBook is that our understanding of how best to regulate the financial system has improved considerably since the onset of the Crisis. While the individual writers may disagree on the merits of particular regulatory initiatives, they all recognise the complexity of the problem, and all have made significant contributions to our mastery of financial regulations.